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Accuray Inc. (NASDAQ:ARAY)

Q3 2013 Earnings Call

May 7, 2013 5:00 PM ET

Executives

Lynn Pieper – IR

Josh Levine – President and CEO

Derek Bertocci – SVP and CFO

Analysts

Steve Beuchaw – Morgan Stanley

Deepak Chaulagai – Dougherty & Company

Jason Wittes – Brean Capital

Anthony Petrone – Jefferies Group

Charles Croson – Sidoti & Company

Operator

Good day ladies and gentlemen, and welcome to the Q3, 2013 Accuray Incorporated Earnings Conference Call. My name is Alison and I’ll be your operator for today. At this time all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of the conference. (Operator Instructions) As a reminder, this call is being recorded for replay purposes.

And I would now like to turn the call over to Ms. Lynn Pieper. Please proceed.

Lynn Pieper

Thanks, Alison. This is Lynn Pieper, Accuray’s Investor Relations Capital from Westwicke Partners. Thank you for joining us today on our conference call, as we review Accuray’s third quarter of fiscal 2013. Joining us today is Josh Levine, Accuray’s President and Chief Executive Officer and Derek Bertocci, Accuray’s Senior Vice President and Chief Financial Officer.

Please note that today, we will be referring to information, which can be found on a summary slide deck on the Investor Relations page of the Accuray website at accuray.com/investors.

Before we begin I need to remind you that our call today includes forward-looking statements that involve risks and uncertainties. There are a number of factors that could cause actual results to differ materially from our expectations including risks associated to the effects of the introduction of the new CyberKnife and TomoTherapy Systems; commercial execution; future order growth, future revenue growth, future profitability; and guidance for fiscal 2013. These and other risks are more fully described in the press release, we issued earlier this afternoon as well as in our filings with the Securities and Exchange Commission. We assume no obligation to update any forward-looking statements.

And now, I’d like to turn the call over to President and Chief Executive Officer, Josh Levine.

Josh Levine

Thank you, Lynn and thanks to everyone for joining us today as we review our results for the third quarter of fiscal 2013. I’ll begin with an overview of the third quarter with Derek providing a more detailed financial review later in the call. I’ll then wrap up with some commentary on our strategy and outlook and then we’ll open the call up for questions. In my references to financial results, I’ll use non-GAAP numbers as we believe they are a better reflection of the ongoing results of our operations.

In our third quarter, we started to see early signs of improvement in our commercial momentum as a result of many of the actions we have taken over the past several months. While we still have some heavy lifting to do, I’m encouraged by the early progress we have made in improving our commercial execution and unlocking the potential value in the two new products that we announced at ESTRO in October 2012.

In the third quarter, we saw noticeable improvement in new order volume. Gross new product orders totaled $53.8 million during the third quarter of fiscal 2013 up from $39.8 million during the second quarter of fiscal 2013. Net product orders added to backlog totaled $44.1 million up from $17.9 million in the second quarter. Importantly, we are seeing enhanced selling focus and an improving order pipeline across all four of our regions. We are also seeing higher ASPs on our new models, which are positively impacting pricing trends.

Our reported third quarter product revenues were $25.1 million, which were disappointing but not unexpected. These revenue results reflect the impact of a number of factors that we have discussed in previous calls. We expect to see modest improvement in product revenue in Q4. In the longer-term, we expect to see more significant contributions in product revenue from growth in our new order activity.

The trends in our service business revenue and gross margin in the third quarter continued to show strong momentum. At $45.5 million, our service revenue continued to grow contributing over half of our total revenue for the quarter of $70.6 million. Our service gross margin improved to 29.5%. Since our acquisition of TomoTherapy Incorporated, we have consistently improved system uptime, which is now approaching 99% globally.

We have continued the installation of new design component in the existing installed base and installation of our recently manufactured systems, which include the latest generation componentry. All of the latest generation componentry that has been a catalyst for improved reliability has been incorporated into our new Tomo H Series. The result is that we have seen a reduction in service calls and service parts consumption per system. We are clearly turning the corner with improved equipment reliability and growing profitability of the service revenue in our TomoTherapy business.

As anecdotal evidence, what I have just described I had direct input from the head of a major cancer center in Western Europe at the recent ESTRO Forum in Geneva that treats approximately 33,00 patients annually. During their evaluation and final decision making process to acquire another (inaudible) unit, he had heard many stories about reliability challenges affecting early generation TomoTherapy Hi-Art systems. The cancer center made the decision to purchase the TomoTherapy System about 18 months ago and the radiation oncologist confirm that his real world experience has been completely opposite from the poor reliability stories he had heard.

He was successfully treating about 20% of its annual patient volume or roughly 600 patients a year on its Tomo machine with no significant downtime whatsoever. Many other customers with more recently produced machines also confirm these doctors experience. While the early generation Tomo systems did have reliability problems, we see very different levels of product performance and reliability with the units manufactured over the past 15 to 18 months and we expect even better performance from our new Tomo H Series systems. While we expect the positive trend in our service gross margin to continue we do expect it to experience some quarterly variability.

Looking forward we anticipate continued progress in commercial momentum over the next several quarters driven by improved selling focus and sales funnel management the economic and clinical validation of the first commercial installations of our new products and market acceptance driven by the substantial improvement in the reliability of our of TomoTherapy product line. During Derek’s financial review he will provide our ending backlog by product line which should provide increased visibility to assist the near financial modeling.

In turning to our products while the delay has been frustrating we are beginning to see the first commercial installations of both of our new generation product platforms. Two weeks ago during the ESTRO Forum we showcased for the first time in Europe our two new systems the TomoTherapy H series and the CyberKnife M6 Series. During the forum we celebrated the first installation of our Tomo HDA our first Tomo H Dynamic Jaws upgrade our first CyberKnife M6 installation and the first patients treated with both the new CyberKnife M6 and the Tomo H.

The Tomo H series is a fully integrated radiation therapy system designed to treat the full spectrum of cancer patients and when equipped with the new Tomo H Dynamic Jaws technology and above our treatment planning capability it fundamentally changes the products functionality by offering both faster treatment planning and treatment delivery with better dose distribution. This improved functionality allows the TomoTherapy system to be viewed as a mainstream or workhorse product able to treat a broad spectrum of patient (case files) in conventional timeslots.

On the CyberKnife side of our portfolio we now have three of our M6 systems installed one in January and two in April. The first of these new systems has been used to treat more than 200 patients since February. The customer’s product performance experience at this first sight has been extremely encouraging in terms of patient throughput and reduced treatment times and this is just using fixed and Iris Collimators which validates the improved pro-performance characteristics of the new M6 platform when compared to previous generations of CyberKnife. We expect the performance characteristics to improve still further when we add the Multileaf Collimator to the M6 platform.

The M6 is ideally positioned for the trend toward hypofractionation and is the product of choice for developing a full-body radio surgery practice. With the Multileaf Collimator or MLC option it offers greater patient through put and overall treatment speed and can treat a significantly expanded patient universe which improves the economics for our customers. As far as timing of MLC availability we are still on schedule to being to ship starting this summer.

Turning to the status of our commercial organization we have made significant progress in filling critical roles across the sales and marketing organization. We now have talented sales and commercial leadership in place in all of our regions. We are starting to see improving momentum as a result of many of the actions we highlighted in January including more focused sales responsibilities by product platform as well as a dedicated sales team responsible of our installed base Business. As a result we are seeing improvements in overall market and opportunity visibility better sales from a management and most importantly growth in our order pipeline. These elements when combined with what is clearly a growing level of customer interest in our new products we expect will drive order growth overtime.

Finally, I want to provide an update on our cost restructuring efforts which are integral to driving our business model to a level of sustainable profitability. Early in the calendar year we announced the plan to reduce our operating expenses by $40 million. Our goal is to reduce non-GAAP operating expenses to $38 million per quarter during fiscal year 2014 which begins on July 1st with some expected quarterly fluctuations. To be clear we are on track to achieve this goal.

I’ll now turn the call over to Derek to provide you with a more detailed review of our financials and then we’ll wrap up with some closing remarks. Derek?

Derek Bertocci

Thank you, Josh. In reviewing the financial results for the quarter I will focus on our non-GAAP results which we believe are the best indicator of ongoing progress and operations as well as trends that may influence future results.

Our press release provides details of the adjustments between GAAP and non-GAAP results. I will specifically mention if I refer to GAAP results. Product revenue of $25.1 million in the third quarter of fiscal 2013 was down from $33.2 million in the second quarter and down from $61.4 million in the prior year third quarter. This decline was due primarily to the lack of availability of the new CyberKnife and TomoTherapy models that we announced at the ESTRO Meeting in late October 2012 combined with delays in expected shipments from backlog. The first system of each new model has now been installed and used to treat patients. We expect that additional installations and reference sites for these new CyberKnife and TomoTherapy models will contribute to growth in orders and revenue in the future.

Well we expect gradual improvement in fiscal 2014 you should expect product revenue to be seasonally light during the coming summer quarter consist with the pattern seen in prior years. As product revenue rises in the fourth quarter of fiscal 2013 and beyond and as we begin to ship more of the new CyberKnife and TomoTherapy models we expect our product gross margin to return to more traditional levels.

Now I’d like to hand the call back to Josh.

Josh Levine

Thanks, Derek. I’m encouraged by a more aggressive commercial focus and improving commercial momentum. These are early signs that the actions we have taken are starting to get traction. Our order pipeline and new order momentum are both improvements. We are confident that the expanded feature set and functionality of our new products will translated to enhanced economic value for our customers. As a result of all of these factors we anticipate gradual continued order growth.

Before we turn to Q&A, let me describe the financial elements and the critical areas of focus that will help you to track our return to profitability. To achieve breakeven operating profit we are focused on the following three financial elements. First, order momentum when converted to product revenue is clearly the key to our future success. We would need to contribution of approximately $23 million to $25 million in gross profit from product revenue assuming historic levels of gross profitability on product sales this equals $46 million to $50 million in product revenue.

Net orders of $44 million this quarter brings us close to this level of product revenue. Second, service gross profit given the steady growth in service revenue and profitability we expect to be able to be able to achieve approximately $13 million to $15 million of gross profit per quarter in fiscal 2014. This represents a continuation of the improvement we have achieved steadily since the acquisition of TomoTherapy Incorporated. And lastly operating expenses, our goal is to reduce non-GAAP operating expenses to $38 million per quarter during fiscal year 2014 with some expected quarterly fluctuations. As we continue to strengthen our commercial capabilities and improved sales execution we expect to drive sustainable revenue growth and operating profitability over the longer term.

And we are now ready to take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And your first question comes from the line of Steve Beuchaw of Morgan Stanley. Please proceed.

Steve Beuchaw – Morgan Stanley

Hi, good afternoon and thanks for taking the questions everyone.

Josh Levine

Thanks, Steve.

Steve Beuchaw – Morgan Stanley

Josh, I wonder if you could speak to what you are seeing out in the field as you’re launching the new systems on the competitive front, one of the questions that people ask is are these new systems going to do well in head to head bidding, clearly nice pick up in the quarter, can you speak to how much of this has been competitive activity and how you see that dynamic playing out as you were able to get the message out into the field.

Josh Levine

Steve, we are very focused on competitive sockets I think one of the reasons we are earlier in the year talked about the separation on the sales the selling focus split between not just individual product platforms but the new equipment focus on the one hand versus the installed base on the other was exactly to get better focus, better traction if you want to describe it that way and better energy applied to the way we compete for competitive sockets and also the way we compete and drive our activity in the installed base. So it’s a big piece of our focus right now.

Again we’re – we – everywhere when you think about we’re positioned as far as our current market share position everywhere really is a growth opportunity for us, we have no where in the world no where a certainly a domestically here in the states in any of our regions where we don’t have a growth opportunity ahead of us and it really doesn’t require us to win every head to head battle to drive a reasonably big impact to our business and our business model. So it’s a – the competitive activity and the competitive socket focus is a pretty significant part of our thought process right now.

Steve Beuchaw – Morgan Stanley

Thanks, that’s helpful. I want to revisit the conversation that we’ve had in the Q&A in the last couple of calls and that’s how you think about the ramp over the course of the year. In the past we’ve talked about the prior level of net orders is being a logical bogie for the end that’s called the rate at which you exited calendar ‘13 is that still the way that you’re thinking about things or given the strength in the quarter on the order book here, could you be a little bit more optimistic.

Josh Levine

Well, I mean again I – we are – I don’t want to take away from what we’ve done and I think we’re all encouraged about what we saw this quarter as far as improvement in order activity it’s way too early in my mind or anyone else’s mind to declare a victory here and we’re not going to do that. We’ve got our hedged down and we’re going to work keeping our nose on the grindstone if you want to describe it that way we – I think again as we’ve described it we expect to see continued gradual order activity improvement in growth in order activity and over the next several quarters and we – the vast majority of the energy internally at least commercially that we’ve talked about over previous calls is focused on ensuring that our people have the right tools to compete in the marketplace that they’re getting the support they’re getting the front-end lead generation and that the downstream go-to-market support that they need to be effective competitors in the marketplace so if you’d ask me confidence factor why do I expect it will continue to see improvement over the next several quarters I would guess the answer is yes.

Steve Beuchaw – Morgan Stanley

Great. Thanks so much everyone.

Operator

Thank you. And your next question comes from Deepak Chaulagai of Dougherty & Company. Please proceed.

Deepak Chaulagai – Dougherty & Company

Good afternoon, gentlemen. Thank you for taking my questions.

Derek Bertocci

Hi Deepak. By the way it’s kind of hard to hear you Deepak.

Deepak Chaulagai – Dougherty & Company

Sorry, I’ll just – I’ll speak louder.

Josh Levine

Okay.

Derek Bertocci

There you go.

Deepak Chaulagai – Dougherty & Company

Is that good?

Derek Bertocci

Yes, better.

Deepak Chaulagai – Dougherty & Company

Okay. The net orders were obviously really strong sequentially, was there a one product line that was stronger than the other, I recall last quarter you had new TomoTherapy orders that was stronger than CyberKnife, I wonder if that similar dynamic is in place here too.

Josh Levine

Actually from a new order standpoint in the quarter that the activity was reasonably evenly split and I think when we think about opportunity going forward we have opportunities Deepak in both platforms given the new products and our energy again because of enhanced selling focus with the dedicated group focused on each product platform we think that’s the best way to drive enhanced presence in the marketplace for us and better selling focus and better more aggressive competitive capabilities in the field.

So I think there are opportunities on both sides of the portfolio going forward. I think that the CyberKnife the encouraging thing about the product performance characteristics about the CyberKnife and M6 that we’d seen in the some of the newest installations or that the vacation throughput that the efficiency and overall capabilities functionality wise of that system even without the MLC are showing dramatic improvement over the previous generation device so we think we’ve got great growth opportunities in both parts of the portfolio and it’s nice to have the beginnings of these reference site installations taking place.

Deepak Chaulagai – Dougherty & Company

Certainly. So you still think the commercial launch for both products somewhere in the summer of Q1 fiscal 2014 or I believe Tomo will be launched earlier than CyberKnife but you see refreshes to what those alternative dates are.

Derek Bertocci

Yeah, just to be clear Deepak we have installations that have already taken place.

Deepak Chaulagai – Dougherty & Company

Right.

Derek Bertocci

First installations of both devices, actually that the first of the CyberKnife installations took place back in probably early February, the first of the TomoTherapy installations took place much more recently. So but again there that the first of again the reference site activity that we’ve alluded to in previous calls and that becomes kind of the starting point for us to be able to get real-time product feedback and product capability inputs from customers that are using the devices, the three patients with in conversations with other customers who are considering those devices in their equipment purchase decisions.

Deepak Chaulagai – Dougherty & Company

Right, understood, but the Multileaf Collimator hasn’t been installed yet right?

Derek Bertocci

We, no we basically are saying that the timing of the MLC is still on schedule as we communicated earlier with regards to beginning shipments this summer.

Deepak Chaulagai – Dougherty & Company

Yeah.

Derek Bertocci

And so that hasn’t changed again I think that the important note there is that we are actually seeing improved functionality in terms of product throughput patient, treatment capability in terms of treatment times off of the M6 would just fix an Iris Collimators that’s certainly has been the experience, the product experience in the first site that’s been installed in Europe and that actually is a great new story for us, because it was already a terrific product and this just assess to us that even without the MLC it’s a better device than the previous generation product.

Deepak Chaulagai – Dougherty & Company

Right, and last in terms of sales force realignment restructuring it’s good to hear that’s almost are complete, in terms of the maturity of the sales force or the ramp-up how should we expect each of your four reasons to perform I’m assuming one reason the U.S. in general be certainly better than the rest, because it’s more mature and your sales force is more has that more time with the products than the other regions?

Derek Bertocci

Yeah so a couple of I guess just a couple of points that Levine said the thought process around this. We again we’ve seen good traction and improving commercial momentum and execution but this is still are work in progress that’s I think point number one then I would make point number two Deepak, is that from the time that we started to talk about the sales force realignment if you want to describe it that way, we were adding people in certainly in the commercial leadership roles at different points in time over the last three or four months.

So, we are basically, most recently finished that process of commercial putting commercial leaders in place in the Asia-Pacific region probably sometime over the last 45 days we had before that finished out that work and the addition of those people in the EMEA region. So we’ve added those and filled those slots over the course of the last three or four months and, we’re starting to see obviously the longer those people are in place the better energy and the better impact they’re having on the business. So, but I just, I would say it’s a developing situation in terms of the full impact of the new commercial leaders and the sales force realignment I think that while we’re encouraged with what we’ve seen so far it’s still a work in progress and we would expect it to get better over time.

Deepak Chaulagai – Dougherty & Company

Sure. Thank you.

Operator

Thank you. And your next question comes from the line of Jason Wittes of Brean Capital. Please proceed.

Jason Wittes – Brean Capital

Hi, thank you very much for taking my questions. First, Josh you mentioned that you’re very competitive versus the other players out there. I was wondering I know that you’re trying to focus more heavily on these smaller setters were any of these orders too small centers or are you still sort of focused on the larger centers right now?

Josh Levine

I told, Jason I’m not sure.

Jason Wittes – Brean Capital

Well you talk about focusing a little bit more on the three like last centers versus the three or more centers I think traditionally Accuray is up with CyberKnife and TomoTherapy have gone into the larger centers.

Josh Levine

Right, the larger academics and yeah so I would just to be clear I think that we really are probably most focused at this point I mean I don’t want to say that we’re excluding you three plus volt academic teaching facilities but we think that we’ve got a great opportunity probably in dual volt up opportunities or dual volt customer locations and that’s certainly gotten a lot of our focus and a lot of our energy in the thought process around commercial rollout but we have reference sites that are either already installed or will be installed across that represented a cross-section if you will of customers out the world. So they’re not of one flavor or shape if you will all single volt or dual volt it’s a mix.

The other thing I guess I would point out is the other area that has really gotten a reasonable degree of focus and attention from us because we think it’s an opportunity is the GPO and the strategic account opportunity you know I think we alluded to in our January comments that our presence in that channel or that certainly that the market is reasonably underrepresented and underpenetrated and we think that there is opportunity there for us so we have since January with that resources that are focused on just building relationships with Group Purchasing Organizations and Integrated Delivery Networks as well as Free-Standing Proprietary Network. So, we’re getting I’d say we’re getting a much better presence and better and improving market visibility in those channels as well.

Jason Wittes – Brean Capital

Okay that’s fair, very fair. Also wanted to ask you know if you compare this quarter I mean last quarter the order rate was obviously disappointing but I think there was a lot of moving pieces if you were to sort of go back and read the Monday Night Quarterback what exactly would you attribute it sort of the shortfall last quarter too looking back I mean it sounds like from what I could gather the sales force had a lot of moving parts and that definitely hurts you. Is that kind of the way to think about it at this point?

Josh Levine

Yeah I mean I think you know it’s, it really hasn’t changed message-wise since the beginning I mean we, the lack of product availability I mean the gap between our announcing new product systems and the launch of those systems at ESTRO Westfall created a lag or a freeze effect on customers they were either considering purchases or were you know they had orders in the backlog that they postponed or pushed out the delivery of equipment on you know in an effort to learn more about new products some of those were requiring renegotiation of agreements in order to upgrade an order within the backlog but that real world effect of that lag that was created is was not insignificant that coupled with that the sales force restructurings that we had alluded to earlier in the year that were quite frankly had occurred prior to my arrival here we had several restructurings that were I’d say more than just realignments they were wholesale restructurings of the field organization in the U.S. market that was highly disruptive quite frankly to our selling momentum. So, it was, you could describe it as kind of the perfect storm of the confluence of all those pieces coming together but you know independently none were insignificant when you put them altogether they took a total on the quarter.

Jason Wittes – Brean Capital

Right, obviously. And then, just a last question on just the U.S. market. ESTRO has proposed potentially bundling Radiation Oncology payments, there is a few other proposals out there, how is that impacting order rates and how might that impact these of your equipment?

Josh Levine

We are close and are continuing to stay close to not just ESTRO but Radiation Therapy lines and the other groups that are active in Washington with regards to proposed legislation, proposed changes and thought processes around reimbursement and the like. I think you know it’s difficult, I don’t think anyone can completely predict with precision where this is going to land, but I think that when you start to think about the kinds of things from a feed and structure standpoint that might kind of entering the people’s thought processes in Washington.

It seems like case rate reimbursement those types of things we actually think it helps when you think about our equipment and the clinical capability that we have the trends towards hypofractionnation, the trends towards collapsing the treatment timeline or the paradigm into a much shorter time spans we think actually placed our strengths you may not have seen it or you may have seen it but the ESTRO Group put out a word about a revised policy that endorsed SBRT as a first-lien option for prostate cancer which again we think as a terrific opportunity for us and again that hasn’t necessarily yet translated into changes at the reimbursement level but it certainly as encouraging at least in its thought process to encourage the payer side of the world to consider things like CyberKnife for treatment of prostate cancer. So, I mean journey is still out on where this will all end but I think that we are as well positioned as anybody in this discussion. Our high position our capability in radiosurgery we think is certainly, it puts us in a reasonably competitive position given kind of where this thing might add from a future payer strategy standpoint.

Jason Wittes – Brean Capital

Okay Thank you, just one clarification I’ll jump back in queue I mean one of your larger competitor did mentioned that the market for purchasing in the U.S. was clog due to some uncertainty related to reimbursement. I just wanted to know if you saw the same thing this quarter.

Josh Levine

I am on a position Jason to comment on one of our bigger competitor said or didn’t say again we are focused on our opportunities and we think that we’re well positioned.

Jason Wittes – Brean Capital

Great. Thank you very much.

Operator

Thank you. And your next question comes from the line of Anthony Petrone of Jefferies Group. Please proceed.

Anthony Petrone – Jefferies Group

Thanks gentlemen, good afternoon. Just to stay on Josh just on the reimbursement topic for a moment. I mean do you care to throw your line in the sand for potentially where do you think CMS might propose rates come this June and obviously last year the experience was a pretty draconian proposal and then that was mitigated toward the end of the year.

In addition to that the stereo tactic rates I believe were inched up a bit on the hospital side and obviously the proposal on IMRT was negative but mitigated again. So that was positive for Accuray in the sense of CyberKnife but here we have the M6 coming out so just curious to get your thoughts on sort of the dynamic of where your things, things could shake out and how you think that plays up for IMRT and SRS rates? Thanks.

Josh Levine

Anthony listen this is the great, the great pass time right now, I’m trying to predict what CMS will do and I’m going to take a pass on this because quite frankly I’ve learned the hard way in a lot of other areas of med-tech, med-device they’re trying to predict what the people in Washington are going to do around these discussions are in most historical examples next to impossible. I think the thing I would say just generally is this.

It doesn’t matter from a – an environmental standpoint whether we were going to be operating under Obama Care or some of the former healthcare reform the practical reality is that you better have some kind of clinical and economic justification for your technology and the support the validation of your technology from both clinical and economic standpoints and data in order to have I think a viable seat at the table longer term. I think without a health cost management capability or strategy I think you end up running the risk but you end up marginalize.

And I think we feel good about where we’re at with both of those discussions both clinically and economically we’re continuing to fund the studies and the work that that support the use of our products and why they’re the right choice. And whatever the folks in Washington are going to do, it’s impossible to predict where this will land but I think that we feel reasonably optimistic that regardless we’re going to land in a pretty good place.

Anthony Petrone – Jefferies Group

That’s helpful just turning it over to the P&L a couple of questions there and I’ll get back in queue. Obviously the bookings number was up substantially sequentially but yet the full year guidance comes in a little bit here. So, just would be helpful to get an update on the length of the sales cycle. I mean is that still in the process of elongating or has that stabilized in just where does that stand and then want to follow-up on margins? Thanks.

Josh Levine

Yeah I mean I think Anthony just to clarify your question or – to kind of put it in perspective. I mean I think what you were just referring to was really the lag time or the product revenue that we recognized this quarter and you kind of asked the question in length of sales cycle terms the real crux or the underlying driver there is the timeline it takes to get from the backlog to the P&L. And as we talked about just a moment ago and I think Derek referred to in his prepared remarks the bigger impact for that is really the lack of availability of the new products in the quarter the delays in those, the availability of those products and some of the customer effect that I described the four around this lag that was created or the freeze that was created on customers in the backlog taking timely delivery of the equipments – of the equipment that they had on order with us. So, really none of that is directly related to sales cycle time.

Anthony Petrone – Jefferies Group

That’s helpful. I guess that relates also to the last question just on the system margin and so is that purely just an overhead issue or are there other areas, where you potentially can attract system margin expansion or is it just a function of getting that volume as well? Thanks again.

Derek Bertocci

So, Anthony that – that it’s Derek. The – the answer to that is that they really the (account) falls into two areas. One a product mix included almost none of our new models and the new models as Josh pointed out earlier are selling with new features and new capabilities. And so, we’re getting higher price on those. The older models sell at a lower price. So, we did – we did have a mix issue in the quarter.

Secondly, because the volume, the overall volume of sales as well as production was far below normal. The amount of overhead per unit was substantially above, well above normal. So, when you put those two factors together, you end up with the abnormally low margin in the third quarter. I indicated we expect to see improvement in future quarters. In the fourth quarter and in the first quarter, we would expect to see some improvement in shipments and we’ll be – expect to begin to ship the new model so we see some improvement in average selling price and margin in that regard.

But we expect to still see the factory in the fourth quarter working through the production overhang that arose, kind of second quarter because of the delay in getting the new models into production. And in the summer quarter, while we expect it will – again the better than it was in the third quarter. We still see that the summer quarter is traditionally in the quarter as I mentioned where product shipments are relatively seasonally late. So, our overall margins in the summer will still be somewhat impacted by the seasonally late shipments in production.

Anthony Petrone – Jefferies Group

That’s helpful. And just if I can just into the fourth quarter is there anything in there from the product recall or is that de minimis into the fourth quarter?

Derek Bertocci

The costs related to the products that we call are very minor.

Anthony Petrone – Jefferies Group

Okay.

Operator

Thank you. And your next question comes from the line of Charles Croson of Sidoti & Company. Please proceed.

Charles Croson – Sidoti & Company

Hi, guys. Thanks for taking the questions. Can you hear me okay?

Derek Bertocci

Yeah, great.

Charles Croson – Sidoti & Company

Great. Thank you. I might have missed this. I have been bouncing around calls here. So, the breakup in order systems for and orders for the quarter which as others I think, have said definitely a nice improvement sequentially. What was the hospital versus center and then new customer versus old?

Derek Bertocci

Right. Again just in general Charles, I would say that the mix – the product mix and the new order activity was reasonably balanced between the two parts of the platform. And I would say that, that for now at least for this quarter the activity was probably really more of what you would expect traditionally from us, which was more hospital based as opposed to freestanding center. I would – I would expect over time, we’ll start to manage and impact that with the efforts we’re making around the national account and the some of the strategic account focused on GPOs and freestanding center, proprietary networks there. But for now for the quarter that we reported it would have looked customer mix wise similar to the way I had historically, which was more hospital based.

Charles Croson – Sidoti & Company

Okay that’s helpful. And now Derek, one thing I noticed here on the presentation slides, the goal to get around $13 million to $15 million per quarter in service gross profit since you are already there right now and then you will be shipping more – more systems particularly on the Tomo side that will get better service margins and then you might be able to squeeze out some market service contracts. Is that – is that a fair range there is that kind of, is there room for upside on that side or is that low hanging fruit pretty much have been squeezed out in terms of the service gross margin? Thanks.

Derek Bertocci

So, I would say that in terms of whether there is upside I would say that in the long run. Of course the service area we would see that there is potentially further growth beyond that. We would trying to give a reasonable outlook over the next say year or so and we think that that’s a reasonable outlook. As far as whether we’ve captured the easiest low hanging fruit I would say that we’ve made substantial progress on that. We still have systems that are – older systems that have not by any stretch have most of their parts are the newly designed parts installed so we still have improvement that we can make on that. The new systems going out in the field today are considerably more reliable and therefore our costs are getting better and much more in line with the revenue that we’re bringing in.

Charles Croson – Sidoti & Company

Okay, that’s helpful. And then just one last one if I may, the MLC when you guys are started shipping that in the summer, is that going to be starting with limited shipments initially and then once you ship it is there a potential revenue recognition tied to that, that would just be helpful. Thanks.

Josh Levine

Yeah, I mean that the – just to be clear Charles that the systems that are out in the field right now the M6 is that would be getting an MLC on a going forward, we have recognized no revenue related to the MLC so in other words if you looked at the existing customer locations that have an M6 they’ve ordered those orders came in either with fixed or fixed an Iris Collimators and the MLC would be an additional an upgrade to that base platform so the cost or the – that the revenue related to the MLC upgrade would be recognized at the time that they get installed and they get – they go to ATP and get it certified or commissioned.

The first part of your question, the answer is we said we’re on track to begin shipping MLCs this summer that still an accurate assessment. We – I would expected that we will I guess it would probably be appropriate say we’ll be shipping in a limited form but again probably improving over time I think at this point we have customers that don’t want their – they don’t want to disrupt their treatment schedule they don’t want to have to bring a system down for an extended period of time to and potentially deal with the addition of the MLC if the MLC is not something that would be applicable to it big portion of their patient mix at present I mean again we’ve got people that are treating – treated 200 patients in the first several months of this year for the calendar year. And so patient flow and volume is significant and we would time MLC installations around what works for customer site by site kind of considerations.

Charles Croson – Sidoti & Company

Okay. Derek and Josh, thank you so much it’s very helpful. Appreciate it.

Derek Bertocci

Thanks.

Josh Levine

No problem.

Operator

Thank you. I’d now like to turn the call over to Josh Levine for closing remarks.

Josh Levine

Thank you. Well we are encouraged about the early signs of progress we’ve made in improving the operational performance of the business. We’ve recognize that we have more work ahead of us. We’re aggressively focused on those activities that will allow the value in our new products and allow us to become a profitable growth oriented business. Thank you for joining us on this afternoon’s call. And we look forward to speaking with you on our fiscal year end call.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. And good day.

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